So banks are considering giving offshore suppliers more control of their processes to avoid having to pay an extra 17.5% for their BPO services.

Last month the government changed the way businesses pay VAT for BPO services. From January 01 VAT started being charged at the point of use rather than supply. Typically offshore services deals with Indian companies do not include any VAT.

Financial services firms will not be able to claim VAT back, like other businesses, because they do not charge VAT as their services have no value added.

Banks are big users of offshore business process services.

According to Robert Morgan, director at Hamilton Bailey, the legislation has made client and suppliers face some hard decisions. He says he has already noticed three clear trends arising from the introduction of VAT on financial services provided from offshore locations:

– Client extending or offering new services want to choose a supplier who qualifies as a full financial services supplier – which means either full or partial exemption for VAT. Companies like EDS/HP and Capita have an offshore capability which has a Banking license and qualifies as a financial institution supplying services to other institutions. Offshore companies have varying degrees of investment in this regard

– Advisory consultants such a Hamilton Bailey has to work a lot harder to define the scope of services and meet certain requirements with a lot more clarity in order to obtain a percentage of the service to be exempt or partially exempt

– Clients seeking to qualify for exemption on offshore services are having to cede more controls to the service provider in order to qualify for exemption

“Thus all parties have to be far more cautious and far thinking in their strategies,” says Morgan.

Jean-Louis Bravard director at Burnt-Oak Partners who is former global head of financial services at EDS, wrote this opinion for us in December.

“Value added tax is a consumption tax levied on any value that is added to a product or a service. The concept (invented by the French) was first introduced in that country in 1957 and by now dealing with VAT is routine, not only in France but throughout Europe and Asia (where it is generally named GST).”

So why bother writing an article on VAT?

First of all, it is important to be reminded that the key concept in VAT is that personal end-consumers of product and services cannot recover VAT on purchases but businesses are able to recover VAT on the materials and services that they buy to make further supplies or services sold to end-users.

This rule is slightly misleading as in reality businesses only recover VAT in full if they themselves add VAT to the services they sell. Traditionally that has been a problem for banks and insurance companies because historically the bulk of their services have been VAT free.

The world is about to change… from 1 January 2010.

Nothing changes for consumers, who will continue to feed the state machine. However, things will change for businesses for any good or service they transact cross border.

The current practice of charging the exporter’s VAT rate (or exporting VAT free) will now be reversed, which means that a UK business buying a French product will now be levied the relevant UK VAT rate, not the French.

The first impact is that selling across borders is now going to be far more complex as each exporter will need to know tax rates in 27 countries versus one before and more importantly the rules for VAT will make a dramatic impact on non EU sales into the EU.

The problem, especially for banks and insurance companies, is that since VAT was first introduced they are now far more international and rely far more on outsourcing.

Taking an Indian supplier providing BPO services to a UK bank as an example, today the VAT rate is zero but from 1 January 2010 the services will be taxed at 17.5% (assuming the rate returns to that as announced). In a normal business, that would potentially generate a cash-flow issue (between payment and collection of VAT) but in the case of banks only a portion of the VAT is recoverable. A bank with only interest income and no VAT bearing fees would have to pay 17.5% of its Indian bill to the Inland Revenue.

In financial services, VAT issues are not new and various solutions were found to diminish or altogether avoid VAT issues when outsourcing services. BPO offered the argument that VAT should not be levied when an internal process (VAT free) was moved to an external provider using the same employees via a TUPE transfer. If my reading of the new rules is correct, VAT issues remain unchanged within the same country but arise anew even if the service provided is intra-company from a subsidiary (no matter the percentage ownership) located somewhere else in the EU. (My assumption is that intra-country any extra VAT cost may be negotiated away).

There seems to be no scope within the EU directive for companies headquartered in one EU member state to be treated as VAT grouped so that cross charges within the group can be VAT free. While this creates tremendous complexity for most companies, the impact on financial services could be significant.

For example, a UK based bank with an asset management back office in Ireland or Luxembourg will now incur VAT (at the 17.5% rate from 1 January 1 2010) whether it is a subsidiary or has outsourced to a BPO supplier, European or not.

In conclusion, I see three main impacts: The first obvious difference between previous years and 2010 is that tax revenue will most certainly go up as a lot of previously VAT exempt services will now be taxed and not all VAT will be recoverable. This is a stealth tax on financial services and will probably not lead to a mass protest by consumers as taxing banks is a recurrent leitmotiv in the press.

The second difference is that within the EU we will now have a level playing field. Services whether provided from inside the EU or the rest of the world, will now be subject to the reverse charge, whether provided by a third party of within the group. In other words, any service provided to a UK company from any location will incur VAT at 17.5%. Simple isn’t it?

The third issue is for existing outsourcing services contracts. Which party will bear any cost increase? Take the example of an Indian company with a Luxembourg European headquarters re-invoicing BPO services to a UK bank. Assume that the bank recovers only 20% of the VAT it pays, then, from 1 January 2010 the true cost goes up by 14% and this may wipe out a substantial part of the saving generated by the move of the supply to Mumbai.

For a very clear description of the changes I recommend the UK tax authority website.

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One interesting additional issues is that many financial co's were using the UK's wide interpreation of the EU VAT group rules to avoid this problem. They were attempting to bring in non-related co's into their VAT groups to soak up the incured by the bank/insurer.

At the same time as the launch of the VAT Package, the EU has threatened action against the UK to prevent this trick to avoid VAT. There is an interesting explanation on this site www.tmf-vat.com

By the way, the Germans invented VAT; the French were the first to implement.

David is correct regarding Wilhelm von Siemens (a German engineer) who first articulated the concept of a tax levied at the final sale but it was the French who fully developed the idea into a real tax and levied it in the early 50s. The idea then was to reduce fraud as the tax is levied at all levels of the value chain but is actually only paid by the end consumer and the corporations act as benevolent tax collectors! Brilliant form of outsourcing!!!